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Volcker Rule Stirs Up Opposition Overseas

(Dealbook) DAVOS, Switzerland — Usually, it is the banks that are fighting efforts to impose new regulations on the industry. Now, it is foreign governments fighting against bank regulations in the United States.

In the halls of last week’s annual meeting of the World Economic Forum here, Wall Street’s top bankers found a curious ally in their battle to end — or perhaps water down — the Volcker Rule, that part of last year’s Dodd-Frank financial regulation law that says that banks are not allowed to participate in “proprietary trading.” Translation: Banks can’t make risky bets with their own money. The idea, rooted in ending the too-big-to-fail phenomenon, is to separate the risky casino element of Wall Street from the utility role of helping finance the economy.

Yet finance ministers from around the world lined up to whisper in the ear of Timothy Geithner, the Treasury secretary, who made the rounds in Davos on Thursday and Friday, about a specific element of the Volcker Rule that has them apoplectic: The rule says that United States banks — and possibly certain foreign banks that do business in America — would be restricted in trading foreign government bonds. Yet the rule, conveniently, provides an exemption for United States government securities. Every other country is out of luck.

The measure, critics say, is likely to increase borrowing costs for foreign governments, reduce liquidity and make the market for foreign government bonds more volatile, the opponents charge. In the end, it may fall into the category of unintended consequences of a proposed new regulation.

This latest assault on the Volcker Rule comes amid negotiations to resolve the sovereign debt crisis in Europe. The possibility of anything that could increase borrowing costs for countries like Italy, Portugal or Spain, understandably, has government leaders on edge.

George Osborne, the chancellor of the Exchequer in Britain, who was whisked from meeting to meeting here in the Alps, is a vocal critic of the rule.

“I am concerned that the regulations could have a significant adverse impact on sovereign debt markets, including here in the U.K.,” Mr. Osborne wrote in a letter to Ben Bernanke, chairman of the Federal Reserve.

While Mr. Osborne noted that the Volcker Rule carries market-making exceptions for trading — it would let banks buy and sell stocks, bonds and other instruments on behalf of their clients — “in practice the regulations would appear to make it more difficult and costlier to provide market-making services in non-U.S. sovereign markets,” he wrote. “Any consequent withdrawal of market-making services by banks would reduce liquidity in sovereign markets, which in turn would engender greater volatility and make it more difficult, riskier and costlier for countries such as the U.K. to issue and distribute their debt.”

Japanese officials similarly believe the rule “would raise the operational and transactional costs of trading” in Japanese government bonds “and could lead to the exit from Tokyo of Japanese subsidiaries of U.S. banks.”

The Japanese officials, who wrote a letter to a handful of United States agencies said: “Some of the Japanese banks might be forced to cease or dramatically reduce their U.S. operations. Those reactions could further adversely affect liquidity and pricing of” Japanese government bonds. Ominously, the Japanese officials added: “We could also see the same picture in sovereign bond markets worldwide at this critical juncture.”

Mark Carney, governor of the Bank of Canada, who was at Davos, is even more upset about the Volcker Rule, which is named for the former Federal Reserve chief Paul Volcker and is still receiving public comment. He contends that the rule could create its own systemic risk and wreak havoc on the government bond market.

Canada’s five largest banks are so anxious about the rule that they have sent a letter to the Federal Reserve and four other agencies arguing that the rule may be illegal under the North American Free Trade Agreement.

All of these foreign ministers have a point that United States officials may want to consider. There is no question that the Volcker Rule is intended to limit banks from taking too much risk — that’s a smart and noble aim. However, the upshot of the particular provision of the Volcker Rule around banks trading in foreign sovereign bonds could create more problems than it solves. And the amorphous language around what constitutes a proprietary trade and “market making” is so confusing that the result is that banks are going to get out of the market entirely.

Think about it like this: When a bank sells a 30-year bond from say, France, the buyer often sells back an older French bond, say a 30-year bond that now has only 22 years left on it. Traditionally, the bank would buy that bond as if it were a used car that was being turned in for a new one. To keep the car dealership analogy going, the bank would then put the used car on its lot until it can find a buyer, with the car — or bond in this case — sometimes sitting in its inventory for weeks or even months.

Under the Volcker Rule, keeping that car on the lot would constitute a proprietary trade, not market making. And therein lies the problem: If you take the biggest American banks out of the market for foreign government bonds, the price will go up.

“Importantly, banks under the Volcker Rule may now be either unable or unwilling to carry inventory, not only in their trading account but also as a part of their traditional market making and flow trading business,” Lord, Abbett & Company, the mutual fund company, recently wrote in a note to clients. “Inventory promotes transactions that enhance and broaden liquidity.”

However, the Treasury Department studied the impact the Volcker Rule would have on liquidity across markets broadly and concluded that it would be limited.

Of course, the outsize bet that MF Global took on foreign government bonds is a memorable cautionary lesson in why the rule should exist in the first place. Jon Corzine, MF Global’s chief executive, made a highly leveraged bet-the-firm gamble on European bonds. Counterparties were so concerned about that exposure that they effectively closed the firm by no longer trading with it.

Nonetheless, it may be worth the United States government considering alternatives to the way the Volcker Rule is drafted. Otherwise it is possible the Volcker Rule could help exacerbate — rather than prevent the next crisis.

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